艾睿電子 (ARW) 2014 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Arrow Electronics, Inc. second-quarter 2014 earnings conference call. My name is Jasmine and I will be your operator for today. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to your host for today, Mr. Stephen O'Brien, Director, Investor Relations. Please proceed, sir.

Welcome to Arrow Electronics' second-quarter conference call. I'm Steve O'Brien, Director of Arrow's Investor Relations program. I will be serving as the moderator in today's call. If you would like to access today's call via webcast, please visit our Investor Relations website at www.Arrow.com\investor and click on the webcast icon.

With us on the call today are Mike Long, Chairman, President and Chief Executive Officer; Paul Reilly, Executive Vice President, Finance and Operations and Chief Financial Officer; Andy Bryant, Chief Operating Officer of Global Components and Global Enterprise Computing Solutions; Eric Schuck, President, Global Components; and Sean Kerins, President, Global Enterprise Computing Solutions.

By now you should have all received a copy of our earnings release. If not, you can access our release on the Investor Relations section of our website along with the CFO commentary and the non-GAAP earnings reconciliation for the second quarter.

Before I get started I will review Arrow's Safe Harbor statement. Some of comments made on today's call may include forward-looking statements including statements addressing future financial results. These statements are subject to a number of risks and uncertainties that could cause actual results or facts to differ materially from such statements for a variety of reasons.

Detailed information about these risks is included in Arrow's SEC filings. We will begin with a few minutes of prepared remarks, which will then be followed by a question-and-answer period.

I will now hand the call over to our Chairman, President and CEO, Mike Long.

Thanks to all of you for taking the time to join us today. We again executed well on our revenue, profitability and cash flow priorities in the second quarter and we are pleased by the returns from our strategic growth investments.

We are mindful of our position in the marketplace, where we deal with a broad variety of technologies and touch upon an extensive number of customers in geographies. We continue to set aggressive financial targets and then to deliver on them.

We are pleased to say we have done so again this quarter. We grew our Global Components business for the fourth straight quarter while the demand environment matched our expectations. Software and services continue to deliver good growth for our Enterprise Computing Solutions business and hardware recovered from the first quarter as we anticipated.

Our consolidated sales were $5.7 billion and diluted earnings per share were $1.43. Revenue and EPS came in above the midpoint of our guidance ranges. We delivered strong leverage on our sales growth as operating income and diluted earnings per share advanced 17% and 20%.

Respectively, year-over-year operating margins were up over last year second quarter in both businesses. Cash generation was again strong at $159 million. Return on working capital at a healthy 27% advanced again year-over-year.

Global Components revenue was above our midpoint expectations. The overall market remained stable with lead times and cancellation rates within the normal ranges. Our sales of $3.6 billion advanced 5% year over year, highlighted by a fifth consecutive quarter of year-over-year growth in Europe.

Book to bill remained positive at 1.04. Operating income grew 14% year over year and the Global Components business has increased gross margins two quarters in a row and operating margins four quarters in a row on a year-over-year basis. Our Global Components business continues to bolster its leading value-added services by expanding design and engineering capabilities, allowing us to deliver increasing value to both our customers and our suppliers.

Enterprise Computing Solutions grew 10% year over year and were flat, adjusted for acquisitions. Operating income grew 12% and billings grew at a mid single-digit rate year over year, adjusted for acquisitions.

In Enterprise Computing Solutions, we continue to move forward on our strategic transformation toward selling comprehensive solutions with the focus on the higher-value segment targeted at the data center. Our comprehensive solutions addressed enterprise customers' entire needs, be they on-premise, in the cloud or a hybrid combination. Both Global Components and Enterprise Computing Solutions are benefiting from the growing demands to generate and capture data from a proliferating variety of Internet-connected devices and security transmit, analyze and store that data.

Paul will now provide an update of our financial results for the second quarter.

Thanks, Mike. Second-quarter sales of $5.7 billion were above the midpoint of our guidance range. Adjusted for the impact of acquisitions and changes in foreign currencies, sales increased 1% year over year. Global Components sales of $3.6 billion increased 5% year over year, above the midpoint of our guidance.

For the fifth consecutive quarter, Europe had strong year-over-year sales growth. Europe sales in constant currency advanced 4% year over year with particularly strong results in Southern Europe. Sequentially, poor sales in Europe were in line with traditional seasonality and our expectations.

In the Americas our sales were up 2% year over year. Americas' core sales were up 4% quarter over quarter within traditional seasonality. Sales in Asia grew 5% year over year and 8% quarter over quarter, in line with our expectations.

Global Components gross margin increased year over year, marking the second consecutive quarter of year-over-year increase. Global Components operating margin of 4.6% increased 40 basis points year over year. And our goal remains to deliver a 5% operating margin in 2014.

Sales in our Enterprise Computing Solutions business were $2.1 billion, well ahead of normal seasonality and in line with the midpoint of our expectations, driven by continued growth in our software and services businesses and by a rebound in our hardware-related business following a spending pause during the first quarter.

In the Americas, sales grew 34% quarter over quarter and grew 1% year over year. In Europe, sales grew 17% quarter over quarter. Europe sales in constant currency advanced 26% year over year, primarily due to the acquisition of Computerlinks, adjusted for the impact of acquisitions -- that's principally Computerlinks -- sales declined 1% year over year in constant currency in Europe.

In both the Americas and Europe year over year, growth in software and services were offset by decline in proprietary service. We are pleased with the growing mix of high margin software and services within Enterprise Computing Solutions and believe profit growth is a far better measure of the market's uptake of our solutions.

Enterprise Computing Solutions gross margin advanced year over year due to the more favorable mix of security and infrastructure software, as well as services. Operating income grew 20% year over year in the second quarter and operating margin of 4.8% was up 40 basis points year over year.

Our consolidated gross profit margin was 13.2%, up approximately 20 basis points year over year, principally due to both the margin improvement in our European components business and to more favorable mix within our ECS business. Gross margin declined sequentially by 70 basis points on a higher mix of ECS sales.

Consolidated operating expenses increased 5% year over year on an absolute dollar basis. When adjusted for the impact of acquisitions and changes in foreign currency, operating expenses decreased 3% year over year. Operating income was $229 million, a 17% year-over-year increase. Operating margins advanced year over year as well, increasing by 40 basis points to 4%.

Our effective tax rate for the quarter was 28%. Net income was up 16% year over year to $144 million. Earnings per share were $1.43 on a diluted basis, toward the upper half of our guidance range, and advanced 20% year over year. Cash generation from operating activities in the second quarter of 2014 was $159 million and $580 million on a trailing 12 month basis.

Return on working capital for the second quarter was 27.2%, up nearly 300 basis points over last year. And return of invested capital was 10.5%, also up year over year. We repurchased $50 million of our stock in the second quarter of 2014, $125 million through the first half of this year.

The Board of Directors authorized an additional $200 million of repurchases in May and the current remaining authorization under our share repurchase programs stand at $226 million.

Over the last four years we have returned $1 billion to our shareholders in the form of share repurchases. Our capital priorities, funding organic growth, accretive M&A and returning excess cash to shareholders remains the same.

This is a high level summary of our financial results for the second quarter. For more detail regarding the business unit results, please refer to the CFO Commentary published this morning.

Now turning to guidance, we believe that total sales will be between $5.25 billion and $5.65 billion with Global Components sales between $3.55 billion and $3.75 billion and then, Global Enterprise Computing Solutions sales between $1.7 billion and $1.9 billion, all for the third quarter. We expect earnings per share on a diluted basis, excluding any charges, to be in the range of $1.26 to $1.38.

Our guidance assumes an average tax rate in the range of 27% to 29%, average diluted shares outstanding are expected to be 100 million shares. The average US dollar to euro exchange rate in the third quarter to be 1.35 to 1.

Thank you, Paul. Jasmine, would you please open up the call to questions at this time?

(Operator Instructions) Jim Suva with Citi.

Congratulations. A quick question -- it sounds like you are reiterating your confidence in the margin profile of the components business at about 5%. Could you just maybe help us walk through the visibility you have on that or the confidence, because right now 4.6% -- it seems like a stretch. Or was there something pulling it down this quarter? Help us understand that.

And then my follow-up question would be on the SG&A outlook. Do you have a lot of different things entering SG&A, some of them good, some of them headwinds such as restructuring, ERP rollout and M&A? Can you give us a feel for SG&A and what we should expect? Thank you and congratulations.

Yes, I will take the differences, Jim. Obviously the seasonality of Q1 and Q2. When we said we were getting to the 5% we also said last quarter it would not be linear and we forecasted right about where we came in. We have made some investments in the business, good investments towards the sales force. So some of that came online in the second quarter. We saw that. And as you did state, we did have an ARP conversion in Asia PAC although a little bit more de minimis than the investment we made on the sales line.

We are doing some things structurally in the business, and I will have Paul go through that in a minute. But here's basically the punch line we've seen. We see business pretty stable. We see the book to bill at 1.04, fairly stable. We've seen Europe really come online since we did that conversion, what has been a year ago, and finishing up with Italy. We've seen continued improvements there in the profitability. North America, despite GDP being down, has really held their own and grown sales.

And while we've seen a slowdown in the Asian markets, we believe that it will continue to accelerate for us.

And I might add, doing the conversion this quarter, it's the first time that we have done a conversion on a full business that has a run rate of around $4 billion. So, think about -- we did the conversion last time in Europe in three steps.

This is the first time we took the entire business and did a conversion, and we did that this quarter, too. So we had more expense in our business of people participating in the Asia region. So hopefully, that gives you a little bit of an overview of the quarter-to-quarter swings that we saw.

And Paul, maybe you want to add a little clarity to the expense line?

Jim, one other point around Unity, which Mike mentioned. We end up with $5 million more of cost in Asia in Q2, principally all amortization, because we turned it on there. As we've spoken about in the past, there is about a six-month lag before we start to see measurable benefits from new programs.

So, while that's not going to be a step up in Q3, that was a step up in Q2. But we expect to see the benefits starting in Q4 and accelerating beyond that. I would expect that SG&A will continue to trend up a bit in the third quarter for some investments we continue to make that Mike has talked about and spoken about, the investments we are making in sales and marketing. The reality is, we continue to believe we have still industry-leading results whether in absolute operating income dollars and earnings per share, whether in operating income percent, in terms of cash flow, which I think for the first half of this year, our cash flow was 120% of our GAAP net income.

And our returns are up. So, we are making a strategic decision to continue to invest in the business to get growth and we think we can afford to do it. So we feel good about where we are. We think we are taking a measured approach to that, and we think that payoff comes about six months after we make those investments. We will begin to see some payoff from investments we made in the first half of this year, late in Q3 and the definitely through Q4. We will continue to see pay investment as we go forward.

And the trend up on SG&A. Do you mean quarter over quarter or year over year?

Well, year over year we were down in Q2 by I think 3% if you exclude the FX impact and the Computerlinks acquisition.

Keeping in mind, though, that also means that we absorb the extra $5 million of amortization tied to the ERP rollout. So I would expect that year over year, our expense levels would be down in that 1% to 3% range also as we continue to move forward.

Thank you and congratulations again to your team at Arrow.

Brian Alexander with Raymond James.

I just wanted to confirm -- are you still targeting the 5% in the components business for the full year? Because it would seem to imply you have to hit like 5.25% in the second half to get there so I wasn't sure if you were endorsing that for the full year because the investments you are talking about in ERP and sales headcount -- if they don't really begin to pay off till the end of the year, I'm just trying to understand where you get that incremental leverage from for the back half.

We think that if you take a look at the third-quarter forecast you will see improvement there. And we would expect the fourth quarter to tick up again. So we are, at this point, feeling like we are still in that game to deliver on that. And we put the investment in early. We actually saw some sales uplift this quarter from it. And if the market continues to hold and we can continue to see that uplift, we do believe we can get there, Brian.

Okay, and maybe just a bigger picture question about the cycle -- just curious. Do you subscribe to the view that this is the new normal for the components business where cycles are flatter and less volatile and leadtimes should remain relatively short? And if so, is that an optimal condition for your business?

Maybe just talk about the impact that flatter cycles might have on your value proposition, your margin profile and, ultimately, the returns on capital that you are looking to achieve.

I think it's interesting you say that, Brian. We've always said that a flatter cycle is a tougher business for us to manage. It is also less exciting at times. And that is both good and bad. So, in some instances, it takes a little drama out of it for us.

I still believe that we will see some swings at certain periods of time based on technologies that take off in wireless and other types of verticals where the manufacturers would then turn their attentions. I'm still a believer that, if we did see in the industry a 10% increase in sales across the board for everybody, you would probably be in an allocation mode and we would be right back at the tough-to-get inventory levels, customers panicking and ordering. Right now there has been a good balance and I think you could take a look at the last couple of years. We have been relatively successful within that balance. And I, for one, would actually welcome less swings and I would welcome more predictability, because I think under that scenario you can invest easier in things like engineering that we were doing, and see and measure your payback better than when you get these swings.

That's sort of a byproduct of a soft environment. But I also -- or, of a flat environment. But being in this business for 30 years and you guys looking at this business for an awful long time, we just haven't seen that type of thing over the years. And despite the fact that it's been like that, nobody is boasting about their world's economies. The US -- the GDP wasn't anywhere exciting in the first quarter. Europe, by all stretch of the imagination, has been sort of a flat semiconductor market even though we've improved our position there or, some would say, take it back after our conversion. And we've seen some growth in Asia PAC.

But I don't think we've seen everything hit on all cylinders, and when we do I think it's going to be an entirely different scenario than what we see right now.

Thanks for the detail, Mike.

Shawn Harrison with Longbow Research.

I wanted to delve into ECS on two different areas. Number one, just the healthy 40 basis point margin expansion year over year. Wondering if that can continue through the end of this calendar year. And then, second, just wanted to get an update on how do you see the demand environment playing out in the second half, particularly for storage and server products, given the fact that there was a pause in the first quarter, whether there's a risk of that happening again and maybe just whether you see growth rates stable right now or the potential to accelerate.

Yes, as far as we see on the EPS side -- our business now, compared to what it was years ago when it was primarily servers, is really prepared now to service customers on premise and off premise. As we said before, through the cloud or any hybrid combination.

So, we are in a much better position long-term than we were when we were primarily servers. The server headwinds are the piece that you see slowing, offset by really security software and storage, which has not been spectacular.

But I wouldn't argue over something not being spectacular these days. In the near term we expect to be right within our seasonality. And we expect that we will still see a decent fourth quarter. I could maybe have Andy go a little bit into the cloud strategy and why we think that we are positioned pretty well, and maybe that will help address the second half of your question.

Let me pick up, Mike, first on your opening. When you look at our performance for the quarter, we did it in an environment where proprietary server continues to be down year over year significantly. So we have really transformed the business, Shawn. And software and services are now at their highest percentage of our total, since I've been here at Arrow. It jumped again year on year as a percentage of software and services.

And that's driving our OI higher. It's also driving our returns in working capital higher, because there's less physical inventory. Then to the second part of your question and Mike's comment on the cloud, I'm sitting here with Sean Kerins, who now runs the business worldwide. We are always looking at the pipeline and there is some growing in the pipeline for server and storage that we think is building for the second half. There is a rollout of some new products from one of our big suppliers in the proprietary area. So we expect to see that installed base migrate. And there's a big change in server 2003 that's underway.

So I would just say we are optimistic for the second half that we will see some demand pick up on the hardware side. And then finally, the cloud -- we are well-positioned on premise or off premise with our tool Arrowsphere. And you probably noted how recent signing with SoftLayer, an IBM company, VMware and others. So we've got a great mix there in the cloud.

And again, in summary we think the second half is stable and maybe firming up a bit.

That's good. Just to focus in on the margin side of it, margins grew 40 basis points year over year in the second quarter. Is that type of growth rate in the margin profile sustainable through the rest of the year?

So we were up 20 basis points, I think, in Q1, 40 in Q2. Right? So when you look at it, on average we are up 30 basis points over last year. So we don't necessarily look quarter to quarter but we would expect our operating income margin in the business to be up year over year as we go forward. There's lots of different dynamics quarter by quarter but --. So that's really our expectation, an operating income percent will continue to trend up for the rest of the year.

Just a brief follow-up -- 1.04 book to bill -- if I look back, the last time you had a book to bill ratio exiting the second quarter this high was 2010, yet the world is still moving sideways. Maybe if you could help me figure out what a 1.04 book to bill means, relative to what we've seen in the past three years?

Well, what we've seen is an uptick in the backlog. And then you've seen an uptick in the inventory to support that backlog. Because you did see the inventory grow. But if you take a look at the turns of that inventory, they have remained about the same. We are expecting the business to continue to grow and you saw growth rates from the first to the second quarter and then you've seen our third-quarter forecast.

We are still relatively bullish on the business. The book to bill is still showing strength and diversity for us, which is something we like to see where it's spread out amongst the regions themselves. And no one play's totally overpowering the other.

So all in all for us, it's a good, strong business. The backlog is there and we think we are poised to deliver the third quarter. And then on to the fourth quarter we can get another quarter of that book to bill, that's really going to project out the fourth-quarter estimates that we think are going to come forward for you guys. And it's all good news at this point.

Thanks so much, Mike. Congrats again on the results.

Mark Delaney with Goldman Sachs.

My first question is along those same lines, around the inventory levels and quota cycles. I think inventory dollars quarter to quarter came up about $200 million, I think at the midpoint of your revenue guidance for the third quarter. Component sales would be up $80 million to $100 million quarter to quarter. Maybe just talk a little bit about to what extent you are starting to procure inventory for shipments in the fourth quarter and if there's any areas where you are seeing some lead time extension.

It's Paul. So when we look at inventory management our inventory turns were about flat with last year in Global Components. So, we feel good about inventory levels.

With that said, there's two other factors to consider. One is a traditional seasonality type trend. We actually accept or take inventory in, in the month of June for Europe because there's extended holiday periods and distribution centers don't have as many people on hand to receive inventory that we hope to ship in the month of September.

So we may not have seen that last year because the European economy was weaker. But our European business is showing really good growth. So really what has happened is we have added a little bit more inventory to support that higher level of sales in Europe. So it's a seasonal trend, happened to happen this year, didn't happen last year because the European business was weaker.

I don't think that's an indication at all of the overall recovery or pace of recovery in the Global Components business.

The other thing I would point to is deep in mind that we did do the Unity rollout in Asia. As Mike mentioned earlier, it was for a whole region, something very different, best one we've ever done so far but very different from what we've done in the past. And our team, rightfully so, in Asia took a prudent approach to inventory management. That meant they had more inventory on hand than they normally would have had to make sure there were no stockouts.

The bottom line is we expect to sell that inventory out over the next quarter or two. So I look at that, and I would say, don't jump to the conclusion that we've added 10% uplift, round numbers, in inventory sequentially because we think there's an impending cycle change with an acceleration to market, or there's going to be an extension in lead times. I think some of it is the normal seasonality that Europe is getting back to more normalcy. Some of it is around community rollout.

You may not have noticed that as much in the past because we did a third of a region in each of the previous rollouts, so it's less likely to have a bigger inventory -- noticeable inventory impact. So I just wouldn't forecast that out to be anything other than, hey, we are managing the region, it's turning around from the sales point of view; and, two, more so around a prudent approach to inventory for a big region like Asia.

I appreciate your perspective on that, Paul. For a follow-up question I'm hoping to talk a little bit on the Ultra Source part of your business. I don't think that has come up recently. If you could just talk a little bit about what you're seeing from a sales and pricing perspective in the Ultra Source components business?

The one thing that I would say is, probably not going to talk about pricing because everybody knows Ultra Source is really dependent upon a single supplier, and we don't like to talk about single suppliers. With that said I would say that sales were up good in Q2, up at a good rate, over 10%. So we feel very good about that. We don't see anything really that's upsetting in the marketplace right now around a trend that is going to dramatically change up or down.

Thank you very much.

Matt Sheerin with Stifel Nicolaus.

I just wanted to go back to the question and issue of your margin expansion in components, that 5% target. It seems, given that the seasonality of the mix of the business typically works against you in the back half of a calendar year, particularly in December with Europe down, Asia flat to up -- so it would seem that the mix on the gross margin side would work against you. So, trying to help understand how we get to the 5% plus margin in the seasonally softer mix of the business.

It's Paul. So to understand the basics of what you all describe, the reality is we have been investing in salespeople, and we think there's a six-month lag between went they come on board and they really get to full speed as far as the selling effort. The contribution margin from their sales is anywhere from 10% to 12%, depending upon -- that's in Global Components in general. And it could be higher in North America and Europe and lower in Asia.

So the reality is that we are looking to outgrow the market because we have more feet on the street, more salespeople being more effective, tied more closely together with our investments in field application engineers, which also drive a differentiated margin. So when we think about it we think we have a chance to drive more sales and more GP dollars. And of course attached to that would not go up meaningfully as we move forward for the second half of the year.

Okay, that's fair. And in the design in terms of the FAEs, are you starting to -- I know, Mike, last quarter you talked about seeing an acceleration in terms of design activity and design wins. Is that still playing out and is that a good indicator going forward?

Yes, design wins is always a good indicator. And I think where we are in the design activity right now is up about 2% year over year. And the first half was around 104,000 design registrations, to give you an idea. That's the magnitude of the numbers that we measure in the productivity from our engineering group.

Once an engineer gets on board it does take them four to six months to get designs that are going to produce anything. And as you know, a portion of those don't produce. But we have definitely seen a correlation since I think we introduced that to you in 2009 between design wins, margin and improvement in the business.

And while 2% doesn't necessarily say it's going to be a barnburner, 2% does say it's growing. And that's the important thing. To go back where Brian brought up before, yes, a little bit slower growth environment but we are seeing the growth, we are seeing the firming in the margins and we are seeing the business come in. And I think that's just the environment we are in.

So I don't see it as an alarming trend right now and I think with more engineers we will actually be able to skew that number more in our favor. And that's really what we were attempting to do with some of the investment.

Okay. And just switching to the computing segment, where you are not seeing a lot of organic growth and I understand they're talking about these product cycles coming later in the year, which were encouraging. But have you seen any negative impact from some of the channel changes with suppliers, particularly the IBM program, giving some product to Ingram and Tech Data? Have you seen any share issues yet or any issues with that?

We have seen absolutely nothing from the IBM change, Matt. In fact, I'm not sure if the other guys have booked $1,000 at this point. With very much that de minimis to us, I can't imagine why somebody would want to put a bunch of engineering work into what has been a dying technology. But that's -- for some reason we have to keep talking about it, I guess, to make everybody happy.

Seriously, the proprietary service business has been declining for years. It being open, we don't see a big impact, we don't see it driving to anything different. And obviously, from our results, we haven't been hurt by it.

If I could just add some color around your observation about not much of organic growth -- and you are right, when we look on an accounting basis the reality is that we are now selling -- our billings are up 5% year over year ex-acquisitions, right? Billings. Remember, we talked about the fact that the accounting for certain software sales is on a net basis. We only recognize the GP as revenue.

Understood, yes.

So we are seeing organic growth, we're just replacing with different products. In fact, really the proof in the pudding is the 20% uplift year over year and operating income dollars in the global ECS business. So, I understand there's a lot of moving parts in all of our businesses but we look at it and say that's pretty good growth year over year, 5%, when you consider that it's Europe and North America and the economies are not tearing it up right now.

Just a couple of numbers for you just to help you -- proprietary servers year over year are down about 17%. That's why I'm really ho-hum on the IBM changes. There's really just not that much there that's worth going after. But our services business and software business is up 11% and 15%, respectively, towards that number.

And that just highlights what Paul has said. We really made a move over the last several years to change the complexion of this business and that has also driven some of our margin activity higher, too. And we think that that's a positive and we think that we know how to transition a business of this size. That, coupled with some of the new products and services that we can offer around the cloud, we really think we are in for a good transition and we are following where the market is going. And we think that's going to pay off in the future for us. So hopefully that helps a little.

That's very helpful. Just to (inaudible) on the numbers of the server, services and software as a percentage of your sales, did you break that out?

You know what? I'll have to have the guy get it to you afterwards, I don't have it here at my hands. But you'll see it's a growing number.

All right, thanks for the help. I appreciate it.

William Stein with SunTrust Robinson Humphrey.

Thanks for taking my question. I would love to hear about maybe a little more detail on the breakup in the systems business. It has done very well in the last few quarters despite all the fears around IBM, and also the transition to the cloud.

And again, you've done well in this segment of the business. I'm wondering if you can perhaps give us some idea as to the breakout by product grouping and how it might have changed in the last couple of years -- maybe -- not putting you on the spot too much but any color you can give us in terms of quantifying that shift away from hardware, in particular, proprietary servers to software and services would be helpful.

This is Andy. Let's start with the cloud. I think the one thing we know today about the cloud is it's not an either/or decision. People aren't just saying, I'm going to cloud and leaving the on premise behind. It's very much a blend of on premise/off premise. And we have been very strong in both those spaces. We've built out our ecosystem to serve both those spaces, whether it be on premise, off premise or hybrid.

And so I think as you look at some of the recent results, the cloud sales around the market, things aren't maybe going quite as fast as everybody thought. And we stayed very focused on our data center line card and I think it reflects in our performance.

When you go to the software services line, both of those areas are growing double digit, as Paul highlighted. And particularly, Computerlinks has been a home run. By any stretch of the imagination around that strategy, Computerlinks brought us new capability, new reach. And if you look at our European performance, we had record sales, record operating income and record operating income percent in Europe.

So that's a big validation of that strategy that has paid off. And so, when you look even deeper below that, security is growing at 9% worldwide for us. That's a pro forma number. That's taking into consideration the acquisition of Computerlinks.

So, I'll just sum it up by saying we've moved the portfolio nicely to software and services. Within software, it's security, it's infrastructure, virtualization, all three of those areas are growing quite nicely for us. And that's how you see the performance actually getting better while the server market has been soft.

And any comment on enterprise switching? I forget your presence in that market.

Switching?

Yes, enterprise switching, yes.

Okay. Well, we still represent people like Juniper and Brocade in that space. Actually our networking business has been growing quite rapidly from a smaller number. And so, that has been a very strong segment for us.

Thanks.

Sherri Scribner with Deutsche Bank.

I just wanted to ask again about the ECS segment. I think you said that there was some improvement in the hardware business. I know that the proprietary business has been declining. But can you give us some sense of which pieces of the hardware business are improving and what parts you're most excited about for the second half?

Sure. We saw the industry standard servers go up on the quarter. We saw a 9% increase in EMEA. And year over year that's up about 2%. And as we said, we saw declines in both Europe and North America around proprietary service.

I would just add, Mike, networking up 5%, which is also included in our hardware calculation.

And then just thinking about the margin profile with this shift to more software and services, understanding that you are recognizing a gross profit in the revenue line, would you expect that your profitability and your operating margins to continue to improve in that segment as the business mix shifts?

We just put in a new President of that business. And we wouldn't have done it if we didn't think it could continue to improve. So yes, we absolutely believe he will take what he has and make it better.

Okay, thank you.

Steven Fox with Cross Research.

A couple quick questions -- first, on the ECS profit growth you mentioned a 20% year over year. Can you just remind us what that growth would have been excluding the acquisition? And then I have a follow-up.

I think it was in the 12% range.

Okay, great. There's been a lot of discussion on this already, but going back to some of your prepared remarks about solution sales targeting the data center, is there any more color you could provide in terms of how you are attacking that market, how it is affecting --? Is it too early to talk about how it's affecting the financials and what kind of investment rates we could see in the future there?

Yes, I'll give you a couple of things. In the beginning we announced SoftLayer, an agreement that we do with IBM. And then the rollout of our V Cloud hybrid service with VMware. And then we have a relationship with Microsoft to enable SaaS positioning. Overall we have got several different SKUs, especially if you get involved with our ArrowSphere program -- which, maybe, Sean -- why don't you just add to that a little bit around ArrowSphere. And that will give you a view that it's really a comprehensive program, not only product line-specific, but one that is important and effects our resellers right along with it.

Sure, Mike, I'll be happy to. ArrowSphere is a proprietary platform that we've invested in over the past couple of years. And it's a place where, all of those cloud-based solutions SKUs that we have been signing as part of our new ecosystem reside. And what it does is it enables the existing channel as well as our emerging channel, involving MSPs and other new resellers, if you will, sometimes referred to as born in the cloud -- it really helps them adopt those SKUs as they try and serve their customers' needs, be they on premise, off premise or some combination of the two.

What it does is it helps simplify all the associated provisioning, billing and contract management on behalf of those partners. As a service, recurring revenue is a little bit trickier to manage and this is a toolset that really makes it easier for those sellers to move in that direction.

It's Andy. If I could add that additional comment to your question around how we are changing and attacking the data center, we have two big plays right now that are driving it. Security has become the biggest concern of most CIOs. And Big Data and, of course, our storage offering and analytics has become the driver of the data center. So I would just go back and point to the moves we've made with Computerlinks and how we have grown our storage business. It is really becoming the lead as we go into the data center. And as Sean outlined, cloud is also growing as well.

Great, that's very helpful. And if I could just sneak a very quick one in, Paul, looking at where the inventories are today in dollars and given the growth prospects that we look for, for the second half of the year, I'm not sure if I should think about inventories in absolute dollars coming down before the end of the year and maybe generating a little bit of cash or staying at these levels. Is there an easy way to think about that?

Right. Yes, that's a good question. So I would say that our expectation would be that, depending upon the pace by which we are able to exit some of that excess inventory in Asia, we will see some variability in the cash flow. But you know what? That's quarter by quarter.

Over the next six months I don't expect us to see a dramatic change, negative change in how we are managing our cash. I think as I mentioned earlier for the first half of this year our cash flow from operations was 120% of our GAAP net income. Our target is like 70%. So we continue for the second and third year in a row to outperform that. I expect us to be very healthy in the second half of the year. And we vary quarter by quarter, but we look at bigger chunks. So I don't think there will be any negative impact on cash as we work through the end of the year.

Great, that's very helpful. Thank you.

Ananda Baruah with Brean Capital.

David Ryzhik here for Ananda Baruah. Going back to software and services, is the strength concentrated in particular regions or is it more broad-based? And would September Q guidance assume double-digit growth for both of those segments as well?

This is Mike. I only heard the first part of your question. What we've really seen in the services piece is North America is a little bit ahead of Europe in growth. Europe is around 7% on the services side. And on the software side, Europe is actually leading North America by the same kind of a few percentages as you saw services the other way.

So the good thing about what we are seeing is that the business is learning from each other region to region. And that's really allowing us to grow our sales exponentially because they are sharing best practices between them and they are following suit very good. So it's not one region that's leading the task of the transformation of the business but it's actually both regions. And we have been real satisfied with work they are doing together to make sure that Arrow as a whole is benefiting by this.

Great, thanks. And did September quarter guidance assume double-digit growth for software and services?

I think we are in normal seasonality, right, Paul?

Yes. So you are talking about year-over-year. The same pace of growth that we saw really in Q2 in the first half of the year we would expect to continue in the third quarter.

And one last one, just general commentary on enterprise storage. Any color on traditional versus emerging would be helpful. Thanks.

So this is Sean Kerins here. It's a good question because the storage has been a high-growth segment for us for a great deal of time. We have seen it slow somewhat. I think the market is taking its time to evaluate the emergence of certain new technologies. That includes flash, that includes converged, hyper converged and even things like software define. But in general we have seen pipelines and activity levels improve for storage and so, we think as we look at the full second half, we are fairly optimistic.

Great, thanks a lot, guys.

Amitabh Passi with UBS. Please proceed.

I had a question and then a couple of quick clarifications. On the question I guess, Mike, for the year end you've given all the discussion around cloud in your focus in software and services. Given some of the trends that we are seeing with alternative forms of storage, whether that be Flash, [Riser], Whitebox, switching, alternatives by a host of private and public companies, of these other hardware categories also an area of interest for you within the context of cloud? Or do you think you will increasingly shift your focus more in software and services?

No, they are definitely an interest to us. Storage has been a business around here for a good number of years. And being in the components business, we have absolutely no fears of a technology change. In fact, we had to change the entire computer business to make it what it is today from just the storage house. And I think that we fully understand storage, we understand where it's going, we understand who the players are. We have had some lines we have signed to make sure that we will participate in that growth. And we are really going to be ready for it on all fronts.

I think you'll see it happen slower rather than faster and I think it will be a migration just like we typically see around technology. But we are really not concerned about it.

Okay. And then, Paul, just a couple of quick clarifications for you -- on the Global Components operating margin, can you clarify, is it 5% for the full year or do you think it will hit 5% exiting the year? And then just in free cash flow I think last quarter, you said $300 million to $400 million is the target for the full year. Is that still on track?

Right, so just for clarity on the 5% goal our CEO has set the target of 5% operating income in our Global Components business for the full year, and then the number that you have for cash flow is still what we anticipate being able to deliver for this full year.

Okay, thank you.

Lou Miscioscia with CLSA.

If you haven't had enough, another question on the ECS side. Can you mention how well you are doing on the convert system front in the sense -- that seems to be getting a lot of traction? And the ones that you are partnered with in this space and then a couple more?

Sean Kerins again. So the converged infrastructure market segment has been quite promising for us. I don't want to talk about too many suppliers specifically but suffice to say, we represent all of the solutions that you hear most about in the market and we continue to see above average growth in that segment as compared to storage in general and certainly as compared to service. I think it will continue to serve us well in the future as data centers migrate from traditional standalone servers and storage to things that are more integrated.

Okay. You mentioned that there is going to be a major rollout in the second half on the proprietary line. Are you getting any feedback from clients so far that demand for that is going to show a material rebound from a very, very weak first half and maybe a very weak 12 months?

It's Andy. What we typically have there is an installed base of customers who look at price and performance. And as you know, the new server has been announced. I would only comment that the quote activity is very active and the pipelines are building. But it's hard to put our thumb around that one or put our hands around what it's going to mean by the end of the year.

And then final question is on the gross margin line. When you look back to last year, it was maybe more flattish on a quarter to quarter to quarter basis. This year, very strong gross margin in the March quarter, down quarter to quarter. Is that now more typical? And what can you tell us about the September and December quarters from a gross margin standpoint?

Is that for Arrow?

Are you talking about the ECS business?

That's for the Company in general. The 13.85 to 13.12, which is up materially in the first quarter year over year but then only up modestly in the second quarter year over year.

I think there's a couple of things happening. Right? We are looking at mix here and we look at Arrow Electronics Inc. with the consolidated results. We really manage the Company based upon the segments and the geography. So I'll go back and talk a bit about in our prepared remarks we said that for the second quarter in a row we saw an uplift in GP percent in the Global Components segment.

That's a positive that we see happening. You may recall that we saw it under this extended economic malaise, if you will, more pricing pressure than we had seen in the past. But it always was our belief that it would come back. So we are seeing some of that uplift. We are also seeing some of the impact of the change in the product mix in the ECS business, where we have more software, which carries the (inaudible) on a net basis, certain segments of it, and a positive impact on GP. So right now if Europe -- and then finally, we have Europe, right, Europe components, which is really a very integral part of our business, which had a three-year rollout at Unity but even more impactful was the fact that the economies are so weak there.

So we have a lot of different dynamics right now that are impacting GPP and driving it upward and, of course, the change in mix for the overall enterprise. So we would expect to see GPP continue to improve on a year-over-year basis. There will be some quarters it will be stronger, in some quarters it will be weaker but it will still be an improvement year over year. That's really what we are focused on.

Good luck in the second half.

We have no further questions. I would now like to turn the call over to Mr. Steve O'Brien for closing remarks.

Thank you, Jasmine. If you have any questions about the information presented today, feel free to contact me. Thank you for your interest in Arrow Electronics and have a nice day.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect and you all have a great day.